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TOKYO – Of all the things Janet Yellen desires in 2021 – a strong US recovery, a stable dollar, patient bond traders – nothing would make the Treasury Secretary’s year more than a time machine.
With it, the former Federal Reserve chair could transport herself back to the scenes of two macro malfeasances now resulting in a possible inflation surge for which the global economy isn’t ready.
The first stop would be Tokyo, circa 2008, to advise the Bank of Japan against making an error that haunts it to this day. The second stop would be February 2018 for a sit down with Jerome Powell in Washington to advise him against following the BOJ’s march of folly.
What connects these events? Central bankers catering to political winds rather than sticking to sound monetary science.
The damage done at both turns explains, in part, why former Fed bigwigs like Bill Dudley, former Treasury chief Lawrence Summers and value-investing guru Warren Buffett are losing sleep over possible interest rate hikes to come.
Dudley, a former head of the New York Fed, goes so far as to warn that “not only will the Fed have to raise rates, but rates are likely to go much higher than investors anticipate.” He warns, too, that increases in the Fed’s benchmark to 4.5% can’t be ruled out (from effectively zero now).
It’s instructive to look at how we got here. Let’s start with the BOJ and its “error origins” story that demonstrates the rashness of the Powell era, which is now backfiring on global finance.
Bad moves by the BOJ
This tale starts in 2003, when then-BOJ Governor Toshihiko Fukui wrote the blueprint for what Yellen would do herself years later – starting in 2015. In 2003, Fukui took the reins from Masaru Hayami, the BOJ leader who pioneered quantitative easing.
In 1999, Hayami’s team had slashed rates to zero as deflationary pressures increased. Two years later, he became the first head of a major central bank to experiment with QE. The Ben Bernanke-led Fed, of course, would follow Hayami’s lead.
When Fukui arrived in 2003, his remit was clear: normalize an ultraloose monetary environment warping bond credit spreads and asset values and, ultimately, deadening the nation’s animal spirits.
Fukui worked gradually to close the QE spigot and mop up excess liquidity inflating asset prices. It was monetary detox of a kind never tried before – and conducted transparently in real-time.
By July 2006, the Fukui BOJ pulled off a 25 basis-point tightening move. And another in February 2007, pushing the benchmark rate to 0.5%. The empire struck back. Politicians, bankers, CEOs and consumer groups circled to register their displeasure.
Even so, the BOJ stuck to its guns – at least, until April 2008, when Masaaki Shirakawa replaced Fukui. From the get-go, Shirakawa was under intense pressure to return rates to zero, bring back QE and put the BOJ on punchbowl-filling autopilot.
The Lehman Brothers crash in September 2008 gave the BOJ all the justification it needed to undo Fukui’s handiwork.
The Fed’s folly
Yellen understands how that feels better than anyone.
It’s easy to forget how controversial it was in December 2015 when the Yellen Fed began hitting the brakes. That hike, the first in nearly a decade, enraged many — none more so than Donald Trump, who’d just announced his run for the US presidency.
Trump and his ilk attacked Yellen incessantly on Twitter and in interviews as she pulled off more rate hikes.
As president, Trump dumped Yellen at his earliest opportunity, replacing her with Powell. To underline his point, and highlight his disdain for expertise of any kind, Trump replaced Yale University PhD Yellen with the first non-economist to run the Fed in four decades.
Much to Trump’s chagrin, Powell stayed the Yellen course at first. To Yellen’s 2015, 2016 and 2017 rate hikes, Powell added a few tightening steps of his own in 2018, getting the Federal Funds Rate up to 2.5% – much higher than the Fukui BOJ did.
After Trump threatened to fire Powell, though, rates began falling back toward zero, even before Covid-19 hit. QE was back too, bigger and splashier than ever before.
So are inflation risks. Which gets us back to Dudley, Summers and Buffett.
Doomsayers on tap
Summers and Buffett, of course, have been hitting the airwaves with overheating worries. Summers, for example, warns that President Joe Biden’s US$1.9 trillion Covid relief bill, and coming multitrillion-dollar stimulus projects, are a “flashing red alarm” that inflation will soon return.
“We were providing demand well in excess over the next couple of years of any plausible estimate of the economy’s potential to produce, and that meant substantial price increases,” Summers argues.
Buffett, of Berkshire Hathaway fame, is voicing his own alarm over recent price data. After rising at 1.4% and 1.7% in January and February, respectively, US prices jumped 2.6% in March year-on-year, spooking investors everywhere.
“We’re seeing substantial inflation,” Buffett told shareholders recently. “We’re raising prices. People are raising prices to us, and it’s being accepted.”
Deutsche Bank strategist Jim Reid notes that ordinary American consumers are suddenly searching for “inflation” online at the highest rates in more than a decade.
“There is little doubt that concerns and interest around inflation are growing exponentially,” Reid notes. “The doves might point out that we saw similar spikes in 2008 and 2010/11 that didn’t ever translate into much actual inflation.
“The hawks would point out that one of the major differences between the post-global financial crisis and post-Covid policy is the scale of the extraordinary fiscal response.”
The brewing bubble
US manufacturing is now growing at the fastest pace in 37 years just as supply chains hurdles, commodity-market scarcity and upward wage pressures bubble up simultaneously.
In March, the Institute for Supply Management’s monthly manufacturing survey jumped to 64.7%, the highest since December 1983. What’s more, various subcategories in the survey could be cause for even greater alarm going forward.
Capital investment is, by some barometers, at its lowest level since the early 1990s. Not a great recipe all around for getting a handle on higher costs.
Hence Dudley’s inflation and concerns – and confusion – over where things stand. Take Dudley’s own dueling inflation views expressed in recent op-eds. On May 10, a Dudley column for Bloomberg carried the headline “Markets Are In for an Interest-Rate Surprise.”
That might come as a surprise to readers of his February 23 piece headlined “Four Reasons Not to Worry About US Inflation” or, for that matter, his December 3, 2020, look at “Five Reasons to Worry About Faster US Inflation.”
Which is it? It is easy to take to task the former Goldman Sachs chief economist. Goldman, after all, does like to vacillate on everything from Fed rate moves to the direction of the Chinese yuan.
But just as likely, Dudley is all of us.
Decades of wrong forecasts
He, like everyone from the Buffetts of the world to the cardboard box company owner in Pittsburgh, is trying to discern whether inflation is coming – or if Japan’s experience with falling prices is the bigger risk.
“After decades of wrong inflation forecasts (typically overestimating future inflation), faith in the prognostication powers of economists and central bankers alike is deservedly low,” argue former UBS forecasters Larry Hatheway and Alex Friedman, now at Jackson Hole Economics.
That makes it exceedingly hard for investors to know how to position themselves for the second half of 2021, or 2022.
It’s an open question, says Allianz advisor Mohamed El-Erian, as to whether inflation is more of a supply problem or a demand-driven challenge. There’s little monetary policy can do about the former. Such imbalances “tend to sort themselves over time” and signal nothing untoward about labor shortages today, he says.
At the same time, though, the dollar’s renewed weakness could be cause for concern.
The currency is languishing at two-and-a-half-month lows after a soft April jobs report that saw the US add only 266,000 positions while unemployment rose. That confusion, along with tumbling US real yields, “is creating a lot of vulnerability for the dollar,” says strategist Daniel Katzive at BNP Paribas.
An added risk is that imported inflation via elevated commodity prices is exacerbated by a weak US exchange rate. That could create the very scenario Dudley fears. And that would ruin Asia’s 2021.
This region’s export-reliant and increasingly indebted economies were reeling at the idea of US 10-year rates rising to 2%, never mind 3% or 4%. China’s factory-gate inflation, it’s worth noting, rose the most in three-and-a-half years in April – up 6.8% from a year earlier.
Were Yellen able to travel back to 2018, she could warn Powell not to let Trump bully him into going back down the QE rabbit hole.
She could warn him, too, that once you swell the Fed’s balance sheet to $5 trillion and beyond, you tend to get trapped. You also create new troubles – from asset bubbles to inflation to the moral hazard that comes with taking the onus off politicians and CEOs to increase competitiveness.
Yellen also could return to 2008 Tokyo and warn the BOJ to stand firm against government officials clamoring for a return to sub-zero borrowing costs. These policies, meant as urgent support, ended up zombifying the third-biggest economy.
There could be worse to come. America’s own monetary excesses could create an even bigger beast – an inflation monster that eats its own.